Saturday, October 20, 2012

Have Hedge Funds Lost the Magic?

Have hedge fund managers lost their mojo? This week another of the industry’s rock stars retired and one of the most successful funds cut its fees, as figures showed hedge funds struggling to attract new money.

The exit, at 41, of Greg Coffey, co-chief investment officer of Moore Capital’s European business, follows a tough three years for the trading style he followed. Freewheeling global macro trading involves bets on currencies, interest rates and broad markets, and has been whipsawed by the on-again, off-again crisis since 2009’s recovery.

Caxton Associates, one of the most successful global macro funds there has been, told investors this week it would cut its fees. That came 10 months after the grandfather of global macro speculation, George Soros, stopped running other people’s money.

Net new investments in hedge funds by the end of September were just $31bn, according to Hedge Fund Research. If the rate remains steady, the only worse years since the turn of the century would be 2008 and 2009.

It is easy to see why investors are falling out of love with hedge funds. The average fund this year returned the same as 10-year US Treasury bonds. During the past 10 years, a portfolio of 60 per cent US equities and 40 per cent Treasuries outperformed hedge funds (see chart).

Even that overstates hedge fund success. Take account of the selective reporting of new hedge funds and of the bias in favour of survivors (when they lose big money they often stop reporting), and academics estimate returns are 3-5 per cent a year lower than indices suggest.

Look at dollars made by investors, rather than percentage gains, and the situation is even worse: clients tend to buy at the top and sell at the bottom. As Simon Lack put it in The Hedge Fund Mirage: “If all the money that’s ever been invested in hedge funds had been put in Treasury bills instead, the results would have been twice as good.”

The death of hedge funds was proclaimed in 2008, when investors were shocked – shocked – to find managers had been gambling on securities that were tough to sell in a crisis. In 1994 investors discovered top managers were heavily geared into lossmaking bond positions. A star of the era, Michael Steinhardt, fell to earth with dozens of others.

Problems were even greater in the late 1960s, when hedge funds turned out to have been anything but hedged. Just as in the mid-2000s, they had turned in stunning performance by gearing up in a bull market. Just as in 2008, when the bull market ended they crashed, and many managers quit.

After each clear-out, the industry recovered, finding new ways to profit and so convince clients to pay astronomical fees. The same could happen this time. Innovations are hard to predict. But so far there has been little clear-out. Painful times lie ahead.

The real problem is a surfeit of money. This hurts returns, because too much money is chasing each trade. It also lets them get away with fees that are far too high. In an era when an 8 per cent annual return looks good, charges of 2 per cent of assets plus 20 per cent of profits cannot last. Some fees are coming down, but even 1.5 and 15 per cent is too high.

At the same time, the industry faces much more competition. What were once hedge fund tricks – short selling, quantitative analysis, high-frequency trading, global macro – are now commonplace. It is harder for hedge funds to gain an information edge, as electronic terminals make data and complex analysis instantly available to all. There are probably as many buffoons as ever to trade against, but at least they are sober after lunch these days.

In short, more competition means lower returns and lower fees until the industry shrinks.

Hedge funds are so large it is extremely difficult for them to outperform. It is more important than ever to pick the best. But how? Weeding out fraudsters and obvious duds is possible, given time and resources. The remaining funds will talk a good game, and most can wow clients with smart analysis and an abundance of brain power.

History shows even managers with Nobel prizes sometimes fail spectacularly, and that with hedge funds, just as with mutual funds, past performance is no guarantee of success. Picking between arbitrage, credit or equity funds may add value – but the same strategies are available passively far more cheaply.

That leaves selecting those with long records. Unfortunately for would-be investors, the best funds restrict the amount they take in. Unfortunately for existing investors, strong demand and limited supply lets them jack up fees. Caxton cut its charges, but only to 2.6 per cent a year and 27.5 per cent of profits.

Hedge funds might produce the next big financial innovation. But as they become more regulated and less exciting, they look more like the products being created by the traditional fund management industry, only with higher fees.

This article just highlights a well-known fact, namely, most hedge funds are charging hefty alpha fees for beta or worse still, sub-beta performance.

While other blogs blame Ben Bernanke for this poor performance, the truth is the industry is full of charlatans who peddle utter nonsense to unsuspecting institutional and high net worth investors. I should know, I used to invest in hedge funds and saw my fair share of hedge hucksters.

Strong returns during the third quarter have boosted the hedge-fund industry to its largest size ever, offsetting a more muted appetite among investors for these types of funds, research data shows.

Global hedge funds now oversee $2.2 trillion in assets, up from $2 trillion at the end of the 2011 and more than double what they invested for their wealthy clients in 2005, new data released by Hedge Fund Research on Thursday show.

Assets grew by $80 billion during July, August and September with some $70 billion coming from better performance and only $10.6 billion coming from net new investments from clients.

So far, pension funds, endowments and wealthy individuals invested only $31 billion net new capital into hedge funds this year, compared with $70.6 billion in 2011, when funds mostly lost money, and $194.5 billion in 2007 just before the financial crisis.

"If inflows continue at their current pace through the end of the year, 2012 would have the lowest inflow total since 2009, when investors withdrew $131 billion from the hedge fund industry," the Chicago-based research said.

This is bleak news for an industry dwarfed in size by the mutual fund industry but able to attract some of the world's savviest investors with the promises of big paychecks and more investing freedoms. Big name investors have long been attracted to hedge funds because their managers can short, or bet against a security, thereby having more tools at their disposal to deliver better returns.

While many large pension funds, including North Carolina and Florida, are still looking to make hedge fund investments, industry data show that investors are becoming more cautious by sticking with established funds and being quicker in pulling money out if they are not satisfied with results.HFR said that clients clearly prefer larger and longer established firms, having sent $13 billion of overall inflows to firms that manage at least $5 billion in assets.

Certain long popular strategies were also hit by redemptions even though they performed relatively well.

Investors removed $5.2 billion from "equity hedge" funds which buy and sell stocks and are up 5.5 percent this year. "Event driven" strategies, which are up 5 percent this year, saw $1.3 billion in redemptions.

Funds pursuing relative value arbitrage strategies, where managers hope to profit from price differentials between related financial instruments, are delivering the year's best returns and are therefore also attracting the most in new money, HFR found. Investors put $12.6 billion in new capital into these types of funds that have gained 7.9 percent this year.

Overall performance at hedge funds has been middling with the average fund gaining 4.76 percent through the end of September. The Standard & Poor's 500 index is up 16 percent this year.

As I reported last week, the pressure is on hedge funds as smart money is falling off a cliff, significantly underpeforming traditional passive strategies. Not surprisingly, investors are pulling out of equity hedge and event driven strategies and allocating more to relative value strategies. But even there, performance varies considerably by strategy and manager.

Finally, for those of you who think hedge funds are dead, think again. After making the headlines for resigning as CEO of Citigroup, Vikram Pandit is now rumored to be on the verge of making a comeback in the hedge fund business. As reported by Kaja Whitehouse and Michelle Celarier in the New York Post, the departing CEO is now rumored to be in the crosshairs of Sutesh Sharma, founder of UK hedge fund, Portman Square Capital.

And Bloomberg reports that John Mack, the former head of Morgan Stanley, is going into business with a 77-year-old tax lawyer who oversees more than $15 billion in investment assets for clients such as ex-basketball star Magic Johnson and the founding family of Estee Lauder Cos.

Mack and Pandit know where the real money lies, and it ain't in investment banking. They will use their relationships to attract high net worth investors to invest in established and emerging hedge funds, charging clients juicy fees in the process. That's ultimately what the real magic in hedge funds is all about, even if most customers are getting duped in the process.

Speaking of magic, in April, Bloomberg "Game Changers" presented an amazing documentary on Earvin 'Magic' Johnson's astonishing post-NBA career as a world class entrepreneur. Below, watch how this NBA legend has achieved a second legacy in business. Unlike most hedge funds, he still has the magic touch.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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